Banks are ready to loan money to US shale

A pumpjack brings oil to the surface in the Monterey Shale, California
Thomson Reuters
Oil prices are rising and the worst of the downturn appears to be over. After two years of spending cuts, 2017 could mark the first time in several years that spending levels across the oil and gas industry increase.

North American oil and gas companies could ratchet up spending by as much as 30 percent, according to Raymond James. That will be possible because banks are finally showing signs of loosening credit once again, after two years of slashing lending.

The credit redetermination period, which occurs twice a year in the spring and fall, has been a closely watched event since the start of the oil price downturn in 2014. Every six months, oil analysts and investors pay close attention to see if banks will cut off drillers, hoping to reduce their exposure to a risky industry. Over the course of 2015, banks showed surprising leniency, considering the magnitude of the downturn and the extraordinary debt levels across the sector. But as the oil bust stretched into 2016, touching new lows, credit became increasingly hard to come by for the most indebted drillers.

Still, the latest credit redetermination period illustrated some evidence that the industry is already passed an inflection point - the oil market is already beginning to rebound. According to Reuters, 34 oil and gas companies saw their credit lines raised by an average of 5 percent, providing an additional $1.3 billion in lending. That is a dramatic turnaround from the 40 percent reduction in credit witnessed over the past three redetermination periods, stretching back to early 2015. Not all companies received more favorable treatment - 10 companies surveyed by Reuters saw their credit lines cut and 12 more were left unchanged.

A major variable in determining the amount of credit offered to drillers is the oil and gas reserves on a company's books. When oil prices collapse, more of the reserves become economically unviable, leading to a reduction in lending. But, with oil prices rising, the reverse is happening: exploration companies are finding that more oil and gas reserves under their possession are now deemed to be profitable, opening up the lending taps. For example, Diamondback Energy, a Midland, Texas oil and gas company, saw its credit line increased from $700 million to $1 billion. "I think we (will) continue to use that borrowing base as a way to fund acquisitions," Kaes Van't Hof, a Diamondback executive, told analysts and shareholders on a November conference call, according to Reuters.

More lending will help drillers in several ways. First, they can use the credit to purchase new acreage, as Diamondback is doing. The Permian Basin has emerged as the hottest play in North America, and companies are scrambling to acquire acreage in West Texas while it is still available. More credit will fuel more purchases, allowing the lucky few who succeed in getting in on the Permian to acquire future production. But more credit also allows companies to access financing, obviating the need to go elsewhere - shareholders in companies stand to benefit if a driller no longer needs to issue new equity. Moreover, drillers do not have to sacrifice future production by selling off producing assets to finance their operations.

The recent rise in oil prices and the prospect of further price gains comes at a propitious time for the oil and gas sector. After years of living on debt, the U.S. shale industry became cash flow neutral for the first time in its history in the third quarter of this year. The shale boom was made possible by debt, but more than two years of consolidation and cost reductions have started to right the ship. The IEA summed up the situation in its December Oil Market Report, saying that "the U.S. shale business model seems on a much more sustainable path," having reach cash flow neutrality in recent months. Higher oil prices will likely mean that the shale industry becomes cash flow positive, although such a development is not inevitable. Higher spending levels will stretch finances, and cost inflation could return as oilfield service companies demand higher rates. "It remains to be seen whether companies can remain cash flow positive when the industry scales up activity and capital spending and as upward pressure on costs once again takes hold," the IEA cautioned.

Oilprice.com

Nevertheless, the shale industry is once again optimistic after getting battered for more than two years. As cash flow improves and banks are starting to offer more credit, spending levels are starting to rise. 2017 will see the shale industry expand for the first time in years.